38 Corporate Finance
maximization rule? In other words, is maximization of shareholders’ wealth an operational concept? If shares
are undervalued, the managers of a company, acting in the interest of existing shareholders, will not sell
stock cheaply. If the company has exhausted its borrowing capacity, the company may have to forgo profitable
projects. Likewise, if shares were overvalued, managers would want to sell shares even when the project is
unprofitable thereby transferring wealth from new shareholders to old shareholders. Ask any CEO what s/he
considers the stock price. Chances are that s/he thinks the stock is under priced. It is possible that managers
may have superior information compared to outside analysts. This does not imply that stock markets do not
reward value-maximizing strategies. The difference of opinion between managers and investors is not on
whether the company is profitable or not but how much profitable and for how long. The increase or decrease
in share price at the time of annual earnings announcements is not due to the short-sightedness of investors.
It is merely an indication of revision of investor expectations. Managers will benefit from interacting with
prominent analysts and eliciting their views on the company’s stock market performance. Even in countries
like India, analysts do a fairly good job of price discovery. Financial markets may not be efficient at all
times. It is enough if they are frequently efficient.
FINANCE THEORY AND FINANCIAL PRACTICE
Many executives and students find finance theory ‘impractical.’ This prompts me to clarify the relationship
between theory and practice. There is a popular feeling that ‘theory’ is opposed to ‘practice’ and that the
merits lie with the latter—this is a false conclusion, based on a false supposition. The theorist essentially
attempts to explain ‘what’s going on.’ If practice has been long successful and does not conform to theory,
the theory is bad and needs to be revised. The distinction should not be between theory and practice; it
should be between good theory and bad theory, between good practice and bad practice. Both are essential
and both must be good.
IN CONCLUSION
The objective of a firm should not be to make a profit or even maximize profit, increase market share or
sales, but to maximize shareholders’ wealth. But this should not be achieved at the expense of other investor
groups. Executives should quit complaining about the rationality of stock markets in pricing securities and
work towards a sustainable increase in the price of the stock. In any company of reasonable size, hundreds and
thousands of decisions are taken every year. How should one establish a link between corporate decisions
and stock prices? Are there some significant decisions, which if handled carefully would lead to increased
shareholder value? In the chapters that follow, four major decision areas in corporate finance—i.e., investment,
financing, dividend and working capital decisions—are described. There is plenty of potential for increasing
shareholder value by improving project choice, debt and dividend policy, working capital decision and
mergers and acquisitions. The interplay between a firm’s macroeconomic environment and the internal ‘capital
market’ is shown in Exhibit 1.7:^24
(^24) Porter (1992).